Reasons not to tap your home equity

You’re feeling the need for some extra cash — with inflation and the high cost of living, who isn’t these days? — and it occurs to you that a worthy source of funds could be within your own house.

The old homestead has a record amount of equity, as its fair market value has increased and you’ve faithfully made your mortgage payments, building up your ownership stake. (In fact, nearly half of U.S. mortgaged residential properties are “equity rich,” meaning their owners’ mortgage balance is less than half their home’s worth, according to property data analyst ATTOM.) So it can be tempting to tap into it via a home equity loan, HELOC or cash-out refinance.

Truth is, though, it may not be a good idea to borrow against your home equity, even if you have sound uses for the funds. The reasons range from the timely (the relatively high interest rate environment) to the eternal (the risks of hocking your house for cash); from current economic forces (an uncertain real estate market) to individual finances (the dangers of a debt overload). (We won’t even get started on the questionable uses, like buying a new car or booking a two-week cruise.)

In fact, according to a recent Bankrate survey, 18 percent of current U.S. homeowners say there’s no good reason to tap home equity for cash at all.

Here’s what to consider when deciding whether to borrow against the value of your house — and why you may or may not want to.

How do you tap into home equity?

Before we delve into the pros and cons, a quick refresher on the basics. There are three primary ways to tap the equity stake you’ve accrued: a cash-out refinance of your mortgage, a home equity line of credit (HELOC) or a home equity loan.

Cash-out refinance

With a cash-out refinance (refi for short), you take out a new and bigger mortgage to replace your existing one. The difference between the two loan amounts is the cash you’ll pocket at closing, which equates to some of the equity you’ve accrued in your property (your lender may require you to keep at least 20 percent equity in your home). Your new loan’s outstanding principal will be higher than that of the loan it is replacing, but you can opt for a shorter or longer term.

“For example, if you owe $100,000 on a home that’s worth $200,000, you can take out a new mortgage for $150,000 and take the remaining $50,000 of equity as cash,” says Rick Sharga, president/CEO of CJ Patrick Company, an Irvine, Calif.-based business advisory firm. “But it’s important to realize that this will increase your debt, from $100,000 to $150,000 in this example, and will generally result in you paying more interest over time.”

You’ll also have to pay closing costs, as you would with most refinances.

HELOC (home equity line of credit)

A HELOC works as an adjustable-rate revolving line of credit. It’s somewhat like using a credit card — only, instead of your debt being unsecured (as it is with plastic), you’ll be required to put your home up as collateral. As with a credit card, you borrow what you need whenever you like (within a finite draw period), repay what you owe, and borrow again if you choose.

With a HELOC, your credit limit will be based on your available home equity; you can typically borrow up to 80 or 85 percent of the value of your home (not counting your unpaid mortgage balance). During the draw period — often the first 10 years — you’ll be required to pay monthly interest on any amount you borrow, but your funds will be replenished as you repay the principal. During the repayment period, funds are no longer accessible and you’ll be obligated to repay the principal and interest over 10 to 20 years, on average.

“This is one of the most common ways homeowners access their equity,” says Seth Bellas, a home loan specialist for Churchill Mortgage. “Many people use a HELOC to make a major purchase, do a home renovation, or for debt consolidation. It’s typically more affordable than a cash-out refinance, and the rate and limit are much more attractive than a personal loan or credit card.”

A HELOC has a variable interest rate that changes as the prime rate shifts — often, from month to month — so your overall balance and monthly payments will fluctuate too.

Home equity loan

A type of second mortgage, a home equity loan is taken out against the equity in your home. As with the HELOC, your home becomes collateral for the debt (meaning you could lose it if you don’t repay the loan); unlike the HELOC, you borrow a set amount, which is paid out in a lump sum at closing.

“Using the previous homeowner example [owing $100,000 on a home that’s worth $200,000], they could borrow $50,000 against the equity in their home and begin making monthly payments on the second loan in addition to their primary mortgage loan’s monthly payment,” Sharga says. Terms vary, but home equity loans can be repaid over as long as 30 years.

“A homeowner with a very good interest rate on their current mortgage loan might consider this option rather than a cash-out refinance, as the latter could charge a higher interest rate,” Sharga continues. Lenders often charge a lower interest rate for home equity loans compared to the rates on personal loans and credit cards. “But second mortgages tend to have higher interest rates than primary mortgages, so borrowers should factor this in before using this option,” he adds.

Reasons not to use your home equity

Just because you can tap your home equity with any of the methods above, it doesn’t mean you should — even if you intend to use the money wisely, such as toward a home improvement project that will increase your property’s resale value. Some of the reasons have to do with the current economic climate, and some are more evergreen and individual, relating to personal finances.

Interest rates remain relatively high

Ponder this reason for postponement: Borrowing money is more expensive right now compared to a few years ago. At the beginning of 2022, interest rates on home-collateralized loans ran in the 4-to-6-percent range, compared to 8.45 to 11.14 percent in August 2024. “Homeowners must reorient to the new reality that home equity borrowing is not low-cost debt” anymore, says Greg McBride, Bankrate’s chief financial analyst.

On the positive side, interest rates for home equity loans and mortgages have dropped as of late and are forecast to decline further in 2024. Expectations are that the Federal Reserve will lower its key interest rate at the next meeting in September. When that happens, interest rates on new home equity loans and HELOCs typically fall as well: They are tied to the prime rate, which tends to move in tandem with the Fed’s decisions.

“A pattern of easing by the Federal Reserve, expected to cut interest rates through the coming months, should result in lower borrowing costs,” notes Mark Hamrick, senior economic analyst and Washington bureau chief for Bankrate.

You can fall deeply into debt

Another reason to kick a home equity tap down the curb is that you’ll be piling on to your total debt, possibly making it more challenging to afford repayment of all of your unpaid balances in the months and years ahead. “Tapping into equity increases your overall debt and what you will owe your lender — both in principal and interest — over time. So it’s important to weigh short-term benefits versus long-term costs,” notes Sharga.

HELOCs in particular can be a trap. “Many homeowners find it difficult to stay disciplined in paying down the principal on their line of credit,” Bellas says. During the initial draw period, “most HELOCs only require you to pay down the interest every month, similar to how a credit card has a minimum payment. By the time the full repayment is due, you will have not only your principal to pay back, but also interest on that principal, making it a pretty steep hill to climb if you aren’t in a great financial position.”

And your financial position could become less-than-great through no fault of your own. A high degree of uncertainty continues to characterize the current economic environment, Hamrick notes. If the economy stumbles or a negative event emerges in the months ahead, job loss and interrupted incomes could cause difficulty for many individuals and households. “Given the high rates of interest that prevail, taking on more debt could be a less-than-optimal decision for some,” he says.

The housing market and home values are unpredictable

If you’ve followed the residential real estate scene closely in 2023, you’ll know that sales and asking prices fluctuated in different parts of the country. In 2024 so far, home price gains have hit an all-time high, making home affordability — and availability — worse than ever.

“Housing affordability may improve slightly but will remain constrained given the shortage of homes for sale,” Hamrick points out. “If mortgage rates continue to decline over the next year or so, we should see some reversal of the so-called lock-in effect resulting in additional homes coming onto the market. The performance of the broader economy will also be key. If there’s a substantial rise in the unemployment rate, that will be a negative for the housing market.”

Although the national economy plays a role, real estate is extremely local. Though up throughout the U.S. in Q1 2024, average home equity gains varied greatly from state to state: from $63,800 per homeowner in California to $600 in Texas. The risk of taking equity out of your home gets especially keen if your local market prices are moving downwards, Sharga emphasizes. “You might ultimately find yourself owing more than your home is worth,” he notes.

Being in such a state of negative equity is rare, but it can happen, if there’s a sharp prolonged drop in local real estate prices, and you’re carrying a substantial amount of debt.

You’re putting your home on the line

With home loan products, the debt you rack up is secured (that is, backed by something) — namely, your home. That also makes the risk greater if you miss payments. Defaulting or being delinquent on other debts is unpleasant and louses up your credit report and score, but that’s it. Here, on the other hand, you’re essentially mortgaging your property, which is probably the biggest single asset you have.

That’s why you have to think extra-carefully about why you want the money.  While using your home equity for a vacation or snazzy new auto might be tempting, it’s a significant risk for a fleeting reward. Vacations build memories but not much else. Cars depreciate in value the moment you drive them off the lot.

Other uses arguably have more merit, but consider alternatives first. College tuition, for example, can often be covered through financial aid or more competitive financing methods (like federal student loans).

Sharga recommends you ask yourself: Is it worth possibly losing your home to foreclosure in the event market conditions worsen or your personal financial situation deteriorates?

Consider, too, that when you liquidate equity, you dilute your homeownership stake. That makes your property a less valuable asset and decreases your overall net worth.

Tips for tapping into home equity

If you are seriously pondering cashing in some of your home’s equity, here are some tips to follow.

• Have a substantial stake: Hamrick says homeowners in the best position to use home equity are those who have accumulated a substantial amount of it — meaning the value of their home is much higher than the amount remaining to be paid off on their mortgage. “This typically includes people who have been in their homes for a long time and have not often refinanced. They should also have a high degree of confidence about their job and income security,” he adds. “Those who have only been in their homes a short time should wait until they enjoy a higher level of home equity.”
• Use it wisely: “Don’t treat home equity like it’s an ATM for purchases you don’t really need to make,” advises Sharga. “Homeownership is a proven way to build up long-term wealth – even providing financial security for multiple generations – and shouldn’t be wasted on frivolous things. Funds should be used judiciously for things like home improvements, paying down higher interest rate debt, or education.”
• Shop around: HELoan and HELOC terms vary widely, so definitely explore options and garner quotes from at least three lenders, including both online and brick-and-mortar institutions. Discuss with the loan officer which type of financing would best suit your purposes and timetable.

Final word on tapping into home equity

You should always do your due diligence and consider carefully before committing to a HELOC, home equity loan or cash-out refinance. Think carefully about your reasons, especially if you want the funds to pay off student loans or credit card balances: Are you basically clearing old debt with new debt? That can be a trap, especially if it means risking an asset like your home.

In addition, many financial experts are concerned about a recession and unpredictable interest rates in the coming months. “While the economy has remained surprisingly resilient over the past couple of years, headwinds remain and uncertainty is still high,” says Hamrick. “To take on more debt when it is so costly carries additional risk.”

Despite all this, drawing out your home equity still might work for you. But weigh the pros and cons carefully before you tap the keg.

FAQ

• How do you build home equity?

  When you borrow to buy a home, your equity is initially equivalent to the down payment you make. The larger your down payment, the greater your initial stake. Over time, you build more equity by paying down the principal balance of your mortgage. Additionally, home improvements that increase your home’s resale value can also boost your equity, as can a general rise in local property values.

• What are the alternatives to tapping into home equity?

  Your home’s equity isn’t the only option if you need to access funds. Unlike home equity loans and HELOCs, personal loans and credit cards are unsecured debts that don’t require using your home as collateral. While they have higher interest rates, applying is typically simpler and faster. You might not be able to borrow as big a sum as with a home equity product, but if your need is for $25,000 or less, these methods might actually be preferable.c